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Posted on October 18, 2018

Major macro risks so far this year have had mostly temporary impacts on markets, all while monetary policy has evolved from accommodative toward restrictive. I still believe the shift in policy (and the accompanying shift in US dollar liquidity) is ultimately the dominant driver of markets. The performance of risk assets and interest rates in the month since my last commentary provides an interesting case in point. Subtle changes in the monetary policy outlook, which were effected almost entirely by Chair Powell, drove markets more than macro risks. Today I’ll recap both macro and policy evolution, which is pretty striking when viewed all together, and then shoehorn it into the Three Phases Model to get a near-term outlook for further market performance.

The list of macro risks was pretty long and it got longer. You probably noticed each of these when they surfaced, but collectively October has a pretty unappealing macro backdrop:

The Italian budget fight between the country and the European Commission is not resolved, and Italy has a 130% debt-to-GDP ratio and cannot unilaterally monetize debt.

The risk of a “hard” Brexit does not appear to have diminished, with the fight over the Irish border still looking intractable.

China-US relations declined further, in both economic and political terms, on three fronts: details of Chinese cyber espionage via the server hardware supply chain in the US spilled out in to the public discourse via multiple Bloomberg News reports; the NAFTA 2.0 agreement contains a “poison pill” preventing unilateral trade negotiations with China and others; and the Trump Administration openly accused China of influencing the US midterm elections.

Jamal Khashoggi’s murder and its shifting explanations threaten the relationship between the US and Saudi Arabia, the world’s top two oil-producing countries.

The US budget deficit ballooned to $779 billion, and government revenue collection under the new tax plan is actually down[1]. despite nearly 6% nominal GDP growth over the last 12 months.

Share buybacks in the US are mostly on hold due to earnings blackout periods.

Separately from all of this, Fed Chair Powell made several appearances since his unnecessarily dovish August speech in Jackson Hole. Rather than definitively walk back that dovishness, his various comments were hazy and lacked a clear message.

At times he was dovish: “the main thing where we might need to move along a little bit quicker would be if inflation…surprises to the upside. We don’t see that. We really don’t see that. It’s not in our forecast….”[2]. “[T]he rise in wages is broadly consistent with observed rates of price inflation and labor productivity growth, and therefore does not point to an overheating labor market.”[3].

He does not see it to be in the interests of the Fed to slow down growth to regulate inflation, despite slow potential growth at full employment: “So if the economy is weakening, then it’s very possible we’d be cutting rates.” And he does not expect growth to slow until the end of the tightening cycle. Responding to a journalist question “[do you see] any kind of specific sign posts that we’ve reached the end of the tightening cycle?” Chair Powell said “…You know if headline growth slowed down.”[2].

At times he was hawkish: “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral…. We may go past neutral. But we’re a long way from neutral at this point, probably.”[3].

He continued to reiterate that the committee does not know where the neutral interest rate (r-star) is, nor does it care: “we don’t want to suggest that either we have this precise understanding of where accommodative stops or suggest that that’s a really important point in our thinking…. [T]hat does kind of amount to thinking less about one’s precise point estimate of the neutral rate. So that’s how I think about it.” Notwithstanding that the SEP dots are fairly consistent in the point estimate of long-run neutral, Powell went on to say: “we have to be humble about how little we really know about where these starred value variables either are or are going.”[2].

There was also some cheerleading of the strong economy, which ultimately resulted in a roundabout declaration that he could soft-land the economy: “Indefinitely is a long time…not every business cycle is going to last forever, but no reason to believe this cycle can’t go on for quite some time, effectively indefinitely.”[4]. Of course, no business cycle has ever lasted indefinitely, and at the September press conference he side-stepped a question about whether he would need to cut rates to soft land the economy.

Ultimately, Chair Powell increased the uncertainty of the policy rate path all else equal, even if not increasing the uncertainty of the Fed’s reaction function. By undermining market confidence in the Fed’s own estimates of the long-run neutral rate, more uncertainty was necessary in market pricing for that neutral rate and ultimately the terminal rate on the current hiking path. Naturally, that uncertainty manifest itself in risk to the upside in the terminal rate, so the 10-year yield went higher and the curve steepened. In practical terms, marginal sellers of Treasury bonds were encouraged to do so.

This move to higher 10-year yields was at least as important a driver of all risk markets as the list of macro risks, and I think the underlying implications for monetary policy of the former (greater uncertainty) will persist for a bit longer. The fact that we had a material rise in long term rates in the beginning of the month of October is important, because October is the month where Fed QT steps up to $50bn per month, and ECB QE steps down from EUR30 to 15bn per month. October is the first month where global G4 central bank balance sheets are now likely shrinking in aggregate.

As a result, I believe the combination of increased interest rate policy uncertainty and accelerated balance sheet reduction has kicked off a mini-Three Phases cycle afresh, as in back to Phase 1. Financial conditions tighten in a fairly uniform way: interest rates go higher, stocks weaken, spreads widen, volatility increases, and the dollar strengthens. It wasn’t perfectly choreographed but generally in the first 10 days of October we have seen Phase 1-type price action, and the Goldman Sachs Financial Conditions Index responded accordingly, reaching the tightest conditions of the year so far. My expectation from here forward is a continuation of the Three Phases in miniature, i.e. next we could see a repeat of the transition from Phase 1 to Phase 2, as the market anticipates the impact of tighter financial conditions on underlying economic performance. Risk assets will stay kind of weak, but Treasurys will rally a bit in a resumption of regular negative correlation between stocks and bonds. It may very well be a macro event which triggers this – back in May of this year, the Italian political crisis was the catalyst for resumption of right-way correlation between stocks and bonds. Then, once there is concern that tighter conditions may impact the economy, the Fed will respond, perhaps offering some clarity on how far until neutral, and emphasizing whether they are planning to pause at neutral. That’ll kick off Phase 3 of the mini-Three Phases, a relief rally in risk and interest rate backup, which may also establish itself as Phase 3 of the major full-year timeframe we have analyzed in these pages so far this year.

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